Liquidity - Current Ratio

What it measures: Liquidity 

How easily a firm can meet it obligations as they fall due / short-term stability;

The proportion of current assets to current liabilities ;

Information drawn from the Balance Sheet;

Represented as a ratio (2.23 : 1)

The equation:

Current Assets / Current Liabilities

What the result means:

For every $1 of current liabilities, the firm has $ _____ of current assets. Firms that have a result lower than 1 have poor liquidity (the firm has more current liabilities that current assets. Negative working capital position.

Typically, firms would like to have a ratio of 2 : 1. This means that the firm has $2 of current assets for every $1 of current liabilities; this means that the firm should easily be able to meet short-term obligations as they fall due.

A result that is too high, however, means that the firm could be making better use of current assets to generate greater productivity (lazy balance sheet).

Sample Statement:

Current Assets ($100,000) / Current Liabilities ($75,000) = 1.33 : 1

The current ratio has a result of 1.33 : 1. This means that the firm has $1.33 of current assets for every $1 of current assets. The result indicates sound liquidity, however, the firm may want to make changes to lift the result to ensure short-term stability.

Ways to improve the current ratio if a liquidity crisis:

• Sell unused non-current assets (this adds to the cash in the firm)

• Refinance short-term debt (increase the size of the mortgage to pay down current liabilities - like credit cards. Here you are shifting liabilities from the current to the non-current part of the Balance Sheet)

• Inject more funds into the firm (via new equity partner or more equity from existing owners - or a new non-current form of debt. Both of these will add cash to current assets)

• Do not use cash reserves to purchase new equipment - lease the new equipment

• Sell non-current assets and lease them back (this provides cash injection to pay down current and non-current liabilities)

Note that only by changing the balance sheet EXTERNAL to Current Assets and Current Liabilities has a significant impact on the Current Ratio. 

The following activities are commonly proposed by students to improve the Current Ratio but they DO NOT WORK.

• Using cash to pay down current liabilities will change the Current Ratio but not to a great extent (you are subtracting the same amount from both sides...) 

• Sell stock at a discount to get more cash (this decreases the total current assets and lowers the Current Ratio - but lifts cash position)

• Sell Accounts Receivables at a discount to factoring business (this decreases the total current assets and lowers the Current Ratio - but lifts cash position)